What Is a Mezzanine Loan?

Definition & Examples of Mezzanine Loans

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A mezzanine loan is a non-traditional form of financing that combines debt with equity for lenders. It has lower priority than other debt in the case of a business failing.

See how these loans work, along with the pros and cons for both borrowers and lenders.

What Is a Mezzanine Loan?

A mezzanine loan is a form of financing that blends debt and equity. Lenders provide subordinated loans (less senior than traditional loans), and they potentially receive equity interests as well.

When a business needs funds for a significant project or acquisition, traditional lenders may be unwilling to provide all of the money required. But creative financing approaches like mezzanine loans might be able to fill the gap.

Mezzanine loans typically have relatively high interest rates and flexible repayment terms.

How Mezzanine Loans Work

Mezzanine loans are a hybrid of both debt and equity. Depending on the terms of the agreement and how events unfold, the arrangement can provide an equity interest to lenders.

Mezzanine lenders usually work with companies that have a successful track record. For example, you might use a mezzanine loan to acquire an existing business or expand operations for a business that’s already profitable.

Interest and Repayment

Mezzanine loans often come with higher costs than traditional borrowing. Interest rates in the double-digits are common, or lenders may demand equity exposure to supplement interest income.

Depending on the terms of an agreement, borrowers may have several options for repayment. If cash flow isn’t available—or if the business wants to reinvest instead of pay interest—businesses can capitalize interest charges, known as a payment in kind.

Subordinated Loans

Mezzanine debt typically has a lower priority than senior debts when borrowers go bankrupt.

If a business fails, it may need to sell assets like buildings and equipment to generate cash and pay off debts. If there’s not enough money to pay everybody, those creditors get in line. 

Banks and senior bondholders are usually near the front of the line, giving them a better chance of receiving payment in a liquidation. (Their interests also may be secured by collateral.)

Mezzanine loans are typically farther back in priority, though they are above common equity.

Pros and Cons of Mezzanine Loans for Borrowers

Like every kind of borrowing, mezzanine loans come with benefits and drawbacks for borrowers.

Pros
  • Access to capital

  • Minimize equity dilution

  • Deductible interest payments

  • Multiple repayment options

  • Benefits capital structure

Cons
  • Financial consequences

  • Risk of equity loss

  • Shared control with lenders

Pros Explained

  • Access to capital: Borrowers get the money they need for a purchase or expansion.
  • Minimize equity dilution: Instead of trading a substantial amount of equity for capital, borrowers can minimize their equity dilution while borrowing more than traditional banks want to lend.
  • Deductible expense: Interest payments may be deductible to the business.
  • Multiple repayment options: Borrowers can potentially pay interest charges with cash, add them to the loan balance, or provide equity-like instruments to the lender.
  • Benefits capital structure: Mezzanine financing often appears as equity on the balance sheet, enabling borrowers to show lower debt levels and more easily qualify for other types of financing.

Cons Explained

  • Financial consequences: Leverage (borrowing money with the hope of earning back more than you borrowed) is always risky. Borrowers may face significant debts and other consequences if things don’t work out as planned.
  • Risk of equity loss: If borrowers default on loans, they may have to provide equity interests to lenders.
  • Shared control with lenders: Mezzanine lenders may set specific criteria that borrowers must maintain. For example, lenders could specify limits on financial ratios or make other demands.

Pros and Cons of Mezzanine Loans for Lenders

Borrowers aren't the only ones who face benefits and drawbacks from mezzanine loans. This type of lending structure has pros and cons for lenders as well.

Pros
  • Interest income

  • Equity and participation

Cons
  • Risk of default

  • Low seniority

Pros Explained

  • Interest income: Mezzanine financing has relatively high-interest rates to compensate lenders for the high level of risk.
  • Equity and participation: Lenders can potentially receive equity, allowing them to participate in a business’s success. For example, warrants may be part of the lender’s compensation, or lenders may receive equity when borrowers default.

Cons Explained

  • Risk of default: Lenders always risk losing money to default, and that’s especially true with mezzanine debt.
  • Low seniority: These loans might not be secured by any physical collateral. For example, there might not be liens on property, equipment, or other company assets. When the business pays senior debtors, they may deplete any available funds before the mezzanine lenders receive payment.

Key Takeaways

  • A mezzanine loan is a form of financing that blends debt and equity.
  • Lenders provide subordinated loans (less-senior than traditional loans), and they potentially receive equity interests as well.
  • Mezzanine loans typically have relatively high-interest rates and flexible repayment terms.
  • Mezzanine debt typically has a lower priority than senior debts when borrowers go bankrupt.
  • Depending on the conditions of the loan, lenders may be able to set conditions of business operations or receive a share in equity if the borrower goes into default.

Article Sources

  1. Minority Business Development Agency. "Mezzanine Financing," Accessed July 14, 2020. 

  2. Comptroller of the Currency. "Leveraged Lending," Download "Download PDF," Page 65. Accessed July 14, 2020. 

  3. Corporate Finance Institute. "Mezzanine Fund," Accessed July 14, 2020. 

  4. Comptroller of the Currency. "Leveraged Lending," Download "Download PDF," Page 64. Accessed July 14, 2020. 

  5. Practical Law Company. "Mezzanine Finance: Overview," Accessed July 14, 2020. 

  6. Comptroller of the Currency. "Leveraged Lending," Download "Download PDF," Page 1. Accessed July 14, 2020.